On My Radar: “The Rodney Dangerfield Expansion”

by Steve Blumenthal of CMG Capital Management Group, 5/4/15

“Earnings don’t move the overall market; it’s the Federal Reserve board. And whatever you do, focus on the central banks and focus on the movement of liquidity. Most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”

-Stan Druckenmiller

Included in this week’s On My Radar:

David Rosenberg
Peter Briger
Lacy Hunt

David Rosenberg

My notes from David’s presentation:

We are in the weakest economic growth cycle of all time.
Working age population growth is vanishing – a big part of the growth story is demographics.
However, while growth is weak, the expansion is the 6^th longest at 69 months.
- The average expansion is approximately 40 months dating back to the year 1857.
David believes this expansion will exceed the record 120 months expansion in the 1990s citing that even though we are at 69 months, we have lower rates and more capacity to grow.
An important point: Bull Markets and Economic Expansions End after the Tightening Cycle – Not when the Fed begins to tighten. This chart shows the Bull Market’s peak 38 months after the first hike and 11 months after the last. Recession’s begin 44 months after the first and 17 months after the last.

The Fed rate hike doesn’t bring an end to economic expansion or a bull market.
It is when the Fed tightens so much that they invert the yield curve and recessions start.
All the bad stuff happens after the last Fed rate hike.
This one will end too but may not end until 2018.
On profit recession discussion: if you strip energy out of the S&P 500, profits are actually up. Energy earnings are down 64%.
Central banks are gobbling up the Treasury supply. Note the drop in marketable Treasury securities outstanding from $2 trillion to $700 billion.

Loved this comment from David – “entities out there are buying bonds because they have to but you don’t. Bonds are unattractive – don’t buy.”
On deflation – “we don’t have deflation.”
On inflation – “inflation is running close to 2.5%. There is more inflation beneath the surface than meets the eye.”
The risk/reward is in stocks – not bonds. Bonds don’t have the coupon protection. The only opportunity is for capital gains and you are buying at extremely low yields.
Liked this next chart: S&P 500 returns broken down into four quadrants. We are somewhere between the two right quadrants (Fed likely to tighten soon).

“When you are in a recession, start to bail” out of the market.
“The U.S. has never been shocked into a recession by another country.”
Concluded that it is a slow motion recovery that gets no respect. Noting that “inflation is the end game and it will be in our future. Central banks will ultimately get what they want.”

Peter Briger – CEO and Co-CIO Fortress Investment Group

Many years ago I ran a large structured trade. We borrowed money from a Wall Street bank and synthetically created a note. Underlying that note was a leveraged allocation to approximately 20 different non-correlating hedge funds. It was a great trade but we closed it at the end of 2007 concerned with the leverage in our note and the leverage in the system.

One of our allocations was to a bright hedge fund manager named Peter Briger. Peter ran and continues to run the credit group at Fortress. Prior to Fortress, he ran a credit group at Goldman Sachs for 15 years. He is one of the reasons I made the trip to this conference. He is super smart and an extremely disciplined investor. When my old friend Jon Sundt introduced Peter to the room, he said he told his wife that if anything happens to me, whatever you do, never sell our family’s investment in Peter’s fund. Unfortunately, we closed our investment with Fortress when we closed our structured trade.

With that, following are my notes from Peter’s presentation:

This lead quote pretty much says it all, “I’m not raising money. Frankly, I’m pretty confused.”
“We invest when the opportunity is good.”
“The world seems very strange and very manipulated. Very hard to draw conclusions.”
He noted his job is to walk into distressed situations and walk out with a bag of money.
“Today, all the easy money has been made.”
“Central banks are sitting around and trying to buy up all the bonds in their respective markets.”
He said he should title this talk “Credit Sucks.”
Liquidity is very high. It is easy for companies to get financed. While it is really hard to get a loan from a commercial bank, it is very easy to get a loan from the capital markets.
He is “sure that we’ll see a high default rate over the next three years – especially on the corporate side.”
The best investment opportunities are in high default environments and commercial banks under duress. Thinks we get high defaults but in this period of highly regulated banks (Dodd-Frank), he doesn’t see banks under as much duress as in prior periods.
“Not saying that banks are not going to blow up again – that’s a certainty. It’s just going to take longer this cycle.”
“Everyone has to think about what will happen to their wealth when interest rates change direction.”
“The whole world is expensive right now” and added, “nobody in this room would want to buy bonds at 0% real interest rates.”
Overall, he sees economies muddle along and banks deleveraged.
Difficult to “fight the global Fed” and a strong worldwide banking system.
In his personal account, he is trying to figure out the best way to short long-term sovereign debt. He said he wants to figure out how to short it without getting screwed. (On this note, my two cents is to buy puts on a foreign bank ETF or directly short the ETF or underling foreign bank stocks, but it is too early in my view for that trade as Draghi is just beginning European QE.

Lacy Hunt (with Q&A lead by the great Gary Shilling)

As one of my favorite sources of insight, Lacy didn’t disappoint. Overall, he thinks that high debt means slow growth and sees nothing that changes that story. He is an economist who is a money manager. He remains 100% invested in 20-year Treasury bonds and his current view is that the yield on the 30-year Treasury bond will drop to 1 ½ % or 2% and when we get there, were are going to stay there for a long time.

Here are my notes:

From history’s many examples of high debt periods, all of which show economic slowdown, there are six periods of high indebtedness similar to today.
In short, we don’t get normal economic growth.
Nominal GDP is the best measure of growth according to Lacy as it is the broadest and most complete measure of economic activity. He noted that the economy can go up, but it can’t stay up. The last five years are below all other peaks since 1948 (chart below).

$10 trillion thrown at the problem and the Fed has quadrupled the size of its balance sheet with little overall impact.
On wages for 70% of households: the level in this decade is below all others since 1965.
Real GDP:

1790-1999 Real Per Capita GDP Growth = 1.9% average annual growth

2000-2014 Real Per Capita GDP Growth = 1.0% average annual growth

The culprit is private and public debt.
Liked this quote: “There becomes a point when the pay later overwhelms the buy now.”
“An over-indebtedness problem can’t be overcome by piling on more debt. And we are piling on more debt.”
80% Debt to GDP is the level where public debt becomes a problem:

USA 110% Debt to GDP

EU 108% Debt to GDP

UK 96% Debt to GDP

Canada 94% Debt to GDP

Important to note: “In the U.S., debt will rise by 1% per year due to Social Security requirements alone.”
On productivity: lowest level since 1982 and below the low reached at the bottom of the great recession.
“When productivity falters, the economy and wages and income can’t grow.”
Monetary Policy – “the mechanisms that work in a low debt environment do not work in a high debt environment.”
The QE money went into the Banks and the banks put it in the Reserve. There has been no growth in M2 money supply.
Velocity of money – we are at a six decade low. “A clear sign that debt levels are problematic.”
Same problem in Japan and the EU – velocity is declining, “the problem is too much debt.”
On the Wealth Effect: He sees little impact on the economy. Families earning less than $150,000 per year have limited holdings in stocks. They are unable to change their lifestyle due to a wealth effect. Those earning greater than $150,000 do have holdings but they are unlikely to change their spending habits.
- No wealth effect – no evidence out there to prove the thesis.
S. economic conditions unlikely to improve for many years to come.

In the Q&A with Gary Shilling:

Shilling sees the 30-year Treasury moving to 2% and the 10-year moving to 1% (his targets).
Lacy 1 ½ % on the 30-year as noted above – “When we get down there, it is going to stay low for a long time.”
Deflation remains the greatest risk and noted the long bond rate is a great indicator of economic conditions (Fed can influence the short end but not the long end).

In summary, there were various views, but what is clear is that traditional return potential is low. Whether it’s Rosenberg’s more optimistic economic view (if you can call it that) and belief that inflation is in our future in 2018, Briger’s “credit sucks” or Hunt’s debt drag – lower long-term rates – deflation remains the greatest risk.

Personal note

As I reflect on the various views on what lies ahead (recession, inflation, default, growth), I can’t help but recall the fact that most economists get it wrong (even the great ones). I lean towards “Don’t Fight the Fed and the Tape”. It is “liquidity that moves markets” as reminded by the great Druckenmiller in the intro quote:

As for recessions, I thought of the piece I wrote last week titled, “Recession Watch – Keep an Eye on This Chart”. For me it takes a lot of economist confusion out of the equation though it is important to take in data from some of the brightest minds amongst us.

Maybe Rosenberg is right, he titled his presentation “The Rodney Dangerfield Expansion – the economy just can’t get any respect.” Perhaps Hunt is right, “the U.S. economic conditions are unlikely to improve for many years to come.” Briger doesn’t’ see great opportunity in credit for several years (but a blow up in credit and the banks is certain). I am in that same camp seeing an opportunity of a lifetime coming in high yield bonds –just not yet.

Stay broadly diversified. Hedge your equity exposure where you can and include a number of diverse risks in your portfolio. Tactical all asset strategies, global macro strategies and tactical fixed income can help produce return, income and risk preservation.

The quant geek in me says to monitor the “recession watch” chart. It seems to me to be a highly probable and disciplined way to identify the timing of recession and take a lot of noise out of the equation.

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On My Radar: “The Rodney Dangerfield Expansion”

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